A Fool's Introduction to Indexes

How many times have you heard someone ask, "How'd the market do today?" But
what is "The Market?" And how do we know how it did? Usually, the answer
reflects the performance of an index, rather than the market as a whole.

Back in 1896, Charles Dow created a benchmark of 12 large U.S. companies to
serve as an indicator of how well stocks in general performed each day. That
was the first broad-market index and it is still the one that is most often
used to answer the question, "How'd the market do today?" In the years since
1896, the Dow Jones Industrial Average (DJIA) has been expanded to include 30
top U.S. companies, and many other indexes have been devised. Still, the Dow
remains the most influential stock index in the world.

But the Dow cannot be all things to all people. A broader stock market index,
the S&P 500, is also quoted often. As you might guess, the S&P 500 is a
listing of 500 of the largest market cap companies traded on U.S. exchanges. It
was created and is maintained by Standard
and Poor's Index Services along with the S&P 400 (400 top mid-sized companies), the S&P 600 (top 600 small
companies) and a couple dozen international and global indexes.

What all indexes have in common is that the value of the index changes
proportionally to the value of the stocks in the index. So when the index
goes up, the aggregate value of the stocks on the index has grown by a
proportional amount, and vice versa.

Other organizations have created their own list of
companies that measure "the market" or a particular subset of the market.
There are indexes that track every publicly traded stock (the Wilshire 5000),
the top 100 stocks traded on the Nasdaq exchange (the Nadsaq 100), biotech
stocks, utility stocks, pet superstore stocks, and stocks that
start with J. (Kidding about those last two, but check back next year. Indexes are a booming business.)

The best thing about indexes is that you can invest in them. Instead of
investing in a mutual fund that pays some Harvard MBA stock picker a salary
slightly larger than the GDP of some third-world countries, index investments
simply buy the stocks that make up a particular index. Voila! Instant fund
sans the human element. And that's a good thing.

Investment returns for index funds will closely match the performance of the
index as long as expenses are low. This is good news for investors who may be
tired of paying that Harvard grad to underperform the market, as about 80% of
managed mutual funds do. Index investing is perfect for novice investors who just want the
benefits of stock ownership without either the hassle or the risks that are
inherent in picking your own stocks.

In our Mutual Funds area we discuss why investors should consider investing
in index products. Before you start putting money in an index, however, take the time to look at a few of the major broad-market indicators to get a better feel for just what an index measures.
We've gathered some basic facts and figures to help you get a feel for each:

Top-weighted companies

Industry composition

Performance over 1- and 3-year periods

Strengths and weaknesses

One final point: Even if you don't invest in indexes, it is important for
individual investors to select an appropriate index against which to compare
the performance of their own portfolios. An investor who gains 7% per year in
stocks could feel very good about that if comparing it to a bank account. But
the fact that her returns trailed those of the Standard & Poor's 500 index
for the same time period would paint this performance in a different light.
After all, she could have matched the S&P 500 by simply investing in the
Vanguard 500 Index Trust mutual fund.